Cosigning a loan for someone is a big deal. Although it might feel like you are just offering a family member or friend a helping hand, the decision could come back to haunt your financial situation and personal relationships.
The decision to cosign a loan means you are putting a lot of trust in the borrower. If anything happens, your finances will be on the line for signing on the dotted line.
Are you considering cosigning a loan? Let’s explore how this action could impact your credit score.
What Does Cosigning Mean?
Cosigning on a loan means that you are financially responsible for the loan. It is one way of building credit through credit piggybacking.
In some cases, cosigning is confused with serving as a character witness for someone. A character witness would simply detail their perception of the borrower’s moral character.
But a cosigner takes things a step further. As a cosigner, you pledge to repay the loan if the borrower cannot. However, you cannot claim ownership of the asset obtained with the loan.
Let’s say your child, Sally, is ready to buy her first vehicle.
Sally needs to take out a $20,000 loan to finance the car. But she doesn’t have a good enough credit score to qualify for the best interest rate and terms. So, she asks you to cosign on the loan due to your excellent credit score.
You agree to cosign on the loan. At that point, she is able to lock in a better interest rate and finalize the car purchase. She is the owner of the vehicle. But you’ll be responsible for making payments if she cannot.
Luckily for both of you, Sally is able to make on-time payments and pays off the loan on schedule.
Why Cosign on a Loan?
Generally, cosigning on a loan is an act of faith in a family member or friend who is just starting to build their credit history.
Without a credit history, a lender might not trust them to repay the loan. But if you trust their judgment, you might feel comfortable giving them the helping hand they need to get started.
It’s never a good idea to cosign a loan for someone you don’t know too well. Since you are promising to repay the loan, it’s necessary to make sure you have full confidence in their ability to repay the loan on time.
4 Times Cosigning Can Hurt Your Credit
Before you cosign on a loan, it’s critical to understand that there are major risks involved.
When you cosign, you are committing to financial responsibility for the loan. That means cosigning can hurt your credit if the borrower doesn’t meet the terms of the loan.
If the cosigner misses a payment, that overdue payment can hit your credit report.
In general, this will only happen when the payment is over 30 days past due. But when it shows up on your credit report, that will have a negative impact.
If the borrower lets you know they won’t be able to make the payment, then you have a chance of avoiding a hit to your credit score. But you’d have to fork over the funds to cover the monthly payment. Depending on your financial situation, covering an extra payment might not always be possible.
If the borrower stops making payments on a car loan, that can lead to repossession. When a vehicle is repossessed, that’s a negative mark on your credit report.
Typically, a repossession happens after a string of missed payments. If the borrower is able to communicate their financial distress, it’s sometimes possible to work out a solution before the repossession happens. But you might need to come up with several payments or a lump sum amount to avert this credit score crisis.
Accounts in Collections
When an account is sent to collections, that’s a bad thing for a cosigner’s credit score.
Of course, these actions will also impact the borrower’s credit report and credit score. But since you are a cosigner, nothing is protecting your credit score from their actions.
When you cosign on a loan, that credit account will appear on your credit report. With that, the debt attached to this credit account will add to your existing debt burden.
In general, an increased debt burden can drag your credit score down.
But the impacts can reach beyond your credit score. If applying for other major loans, like a home mortgage, the lender will also take your debt-to-income (DTI) ratio into account.
The DTI is calculated by dividing your total monthly debt obligations by your income. If you have cosigned on a loan, the lender can include that monthly payment in the DTI calculations. So, that leads to a higher DTI ratio.
Although your DTI ratio is not considered in your credit scores, a higher DTI ratio will have a negative impact on your loan approval chances. For example, most lenders won’t approve a mortgage if your DTI is over 43%. Take this possibility into consideration before committing to more debt.
3 Times Cosigning Can Help Your Credit
It’s possible for a cosigned loan to increase your credit score. Of course, this is the best-case scenario that everyone hopes for when committing as a cosigner on a loan.
Payment history accounts for 35% of your FICO score. That makes it the most important factor in your credit score.
When the borrower makes regular on-time payments, that builds up a positive payment history. So, that will have a positive impact on your credit score.
If everything goes smoothly, the borrower will pay off the loan on schedule. When it is paid off, that is reported to the credit bureaus.
This information indicates to lenders that you are able to manage credit responsibly. With that, your credit score may improve. However, it’s important to remember that paying off loans can also cause your credit score to decrease due to the loan becoming a closed account and the effect on your credit mix.
New Credit Mix
Credit mix accounts for 10% of your credit score. Lenders like to see a mix of both revolving and installment credit accounts.
A few examples of installment credit accounts include personal loans, mortgages, and auto loans. Two examples of revolving credit accounts include credit cards and home equity lines of credit.
Depending on your situation, cosigning on an installment loan could add a different credit account to the mix.
Things to Consider Before Cosigning
At first glance, cosigning on a loan offers a way to help out a family member or friend. If you have a good credit score, you might feel like cosigning on a loan isn’t a big deal.
But the reality is that the choice can have a big impact on both your finances and relationships. So, it’s important to take a closer look at the potential impact before committing to the loan document.
Here’s what you should think about before diving in.
When you first consider cosigning, your thoughts likely turn to the financial impacts. But it’s also important to think about the potential impacts on your personal relationships.
Unfortunately, it’s possible that your family member or friend could stop making payments for the loan. Whether they run into financial difficulties or simply choose to spend their money elsewhere, this action could have a big impact on your personal relationship.
After all, you’ll be on the hook for the funds if they can’t pay. That’s a perfect recipe for conflict. In many cases, it’s best to separate financial transactions and personal relationships. But take the time to consider how your relationship with the borrower might change if their finances go south.
Also, it’s worth pointing out that a divorce won’t absolve you from the financial responsibilities of cosigning. If you cosign for a marital partner, there’s no way out of the debt.
If you aren’t sure about the potential fallout, then have an open conversation with your friend or family member. Try to get on the same page about putting your personal relationship above everything else, even if money gets tight.
Your Own Credit Score
Before you can commit to cosigning, take a look at your own credit score.
As a cosigner, you’ll generally need a good credit score. If you have a bad or borderline credit score, then you likely won’t be able to help a borrower with bad credit obtain the loan they are looking for.
Beyond the ability to cosign, consider the potential negative impacts on your credit score. If you are planning to take out major loans in the near future, you might not want to put your credit score at risk.
If you don’t have any plans to use your credit score for a big purchase in the near future, then taking a risk with your credit score might not be such a gamble.
Your Own Finances
The key point of cosigning is that you’ll be legally responsible for the entire debt. If the borrower is unable or unwilling to pay, the lender can come after you for the funds.
Consider whether or not you can afford to pay off the entire loan. For example, if you are cosigning for a $10,000 personal loan. You might have to pay for the entire thing! Make sure that your finances can sustain such a hit. Even if you can afford the loss, decide if you are willing to potentially derail your own financial plans.
Take a look at the monthly payment attached to the loan. Could you squeeze it into your budget?
If not, you’ll be taking a risk because when a borrower misses a payment, it will hit your credit report. But if you can afford the monthly payment, you can step in to avoid a missed payment. A cushion in your monthly budget can go a long way towards protecting your credit score as a cosigner.
The consequences of cosigning on a loan can get complicated. If you aren’t comfortable, that’s okay! Remember, you can always say no to a cosigning agreement.
Should You Cosign?
So, should you cosign on a loan for a family member or friend?
The answer varies based on your unique situation. Let’s explore when the choice may or may not fit with your finances and personal life.
When Cosigning Makes Sense
Cosigning can make sense if you have a good credit score. But it’s important to have no immediate financing needs on the horizon. Otherwise, you could see your credit score drop right before you apply for a loan of your own.
In addition to a healthy credit score, you should be able to afford to pay off the loan on your own. Remember, cosigners are legally responsible for repaying the loan when the borrower cannot. So, make sure that your financial situation can afford the hit before signing on the dotted line.
When Cosigning Doesn’t Make Sense
If you really want to help a family member or friend, saying no to cosigning can feel hurtful. But sometimes, the reality of your finances isn’t in a suitable state for cosigning.
A bad credit score will eliminate you from the responsibility of being a cosigner in the first place. If you have a good credit score but have financing needs of your own, then skipping out on cosigning may be the right move.
Another reason to avoid cosigning is if you cannot afford to repay the loan on your own. Finally, if you think that cosigning will put a strain on the relationship, it’s better to pass.
If you decide not to cosign, convey your decision with love. Of course, you want to help out a friend. But you can share that your financial situation isn’t ready to cosign for a major financial commitment.
Best Practices For Cosigners
If you decide to cosign, there are some best practices you can implement to protect your credit score. A few include:
- Get access to the online statements: You’ll want to keep up with the credit account on your own.
- Get notifications from the lender: If the borrower is falling behind on payments, ask the lender to let you know.
- Beef up your emergency fund: Make sure you have the funds on hand to cover a missed payment.
- Communicate: Ask for regular updates from the borrower. If they are struggling, it’s better to find out as soon as possible.
Some experts even recommend considering a cosigned loan as a financial gift you are prepared to pay for. With this outlook, you can safely make a decision about whether or not you can afford to help out a friend or family member with bad credit or no credit at all.
And, of course, it’s also important to follow your gut when cosigning. If you love your friend but know they aren’t good at keeping up with payments, then cosigning might not be the right move.
The Bottom Line
Cosigning on a loan will have an impact on your credit score. Depending on how the borrower handles the loan, it could have a positive or negative impact on your credit. Ultimately, you’ll have to decide for yourself whether or not cosigning is worth the risk.